Question

Suppose that the Fed undertakes an open market purchase of $25 million worth of securities from a bank. If the required reserve ratio is 9%, what is the resulting change in checkable deposits (or the money supply), assuming that there are no cash leakages and that banks hold zero excess reserves

Answer 1

$277.75 million

Step-by-step explanation:

First we must determine the money multiplier = 1 / reserve ratio = 1 / 9% = 11.11

A $25 million cash injection into the banking system should increase the total money supply by = $25 million x 11.11 = $277.75

The money multiplier is a concept that explains how the banks create money: you deposit $100 in the bank, the bank lends $91 to another client, that other client spends the money in purchasing goods, the seller deposits the $91 in his own bank, then that bank lends $82 to a different client that purchases something else, and the wheel goes on. In this case, those $100 will generate transactions totaling $1,111.